'The fox knows many things…'

Spaceship or “Space Cadet”?

The title of this post was inspired by comments that I’ve heard poking fun at the technology-based start-up super fund Spaceship. Ridiculing Spaceship (and Zuper, GROW, Cruelty Free, Human and Good) has become something of a sport among some of the established players in the superannuation (pension) industry.

For the record, I don’t think Spaceship, the people behind Spaceship or any of these other funds are “space cadets”. They have very cleverly done something than none of the established funds are able to do: grow their membership very quickly!

For this reason alone, I think they deserve some credit (and perhaps a little envy or fear) from the establishment.

Am I a fan of Spaceship? No, not in its current high-cost, poorly-designed investment portfolio and over-hyped form. But I am definitely a fan of what they’re trying to do. Superannuation is ripe for “creative destruction”.

I believe the seeds of the future of superannuation can be found in what they’re trying to achieve.

Existing super funds have coasted for almost 40 years. They’ve either taken advantage of default contributions (industry funds) or vertically integrated production and distribution (retail funds). Most existing funds have largely stuck to some form of 70:30 portfolio and rode the tailwind of falling interest rates and rising equity valuations.

It’s true that some super funds are trying to make a difference, but you can probably count them on one hand.

Will Spaceship succeed? Hard to tell. The real test will be to see if they can grow beyond their marketing niche of tech savvy hipsters and into the mainstream. Another test will be how they fare when they encounter a market that hits their equity-heavy investment strategy head-on.

Whether or not Spaceship succeeds is beside the point. They have already succeeded in exposing the vulnerability of the existing players to fresh, innovative competition.

What follows is divided in three parts: the Good, the Bad and the Hype.

The Good

Show me another super fund that has acquired as many members as Spaceship has in less than a year? There isn’t one, unless you count funds that merge. I think there are several lessons that all superannuation funds can learn from Spaceship. They are:

Playing the long game

A strong narrative makes compulsory super feel less compulsory

Young people don’t care about advice, insurance, a call centre or any of the other stuff that adds cost to a super fund

Playing the long game

To date, much of the competition in super has been for older members with large account balances. This makes sense for super funds as losing members with large balances reduces scale and pushes up costs. In other words, members with large balances help to subsidise the cost of administering lots of low-balance accounts held by younger members.

Many established funds have set up their own administration platforms. That’s lots of sunk costs in IT systems and high fixed costs for call centres, admin staff etc.

A start-up such as Spaceship is unencumbered by these costs. They outsource all of these “Trustee” functions. My guess is that they probably pay for them on a percentage of assets basis, meaning that their fixed costs are either low or non-existent.

Being free of the need to cover a high fixed cost base allows Spaceship to focus on younger members with lower balances. Why does this matter? Cash flow. Younger members have 30, 40 or even 50 years of contributing 9.5% of their income (increasing to 12%) ahead of them.

In contrast, many established funds are facing a decline in net contributions due to a range of issues. You can see this for yourself by checking out the KPMG Super Insights Interactive Dashboard. The dashboard compares ARPA regulated funds on a range of metrics over the last 10 years.

The chart above shows the FY 2016 cash flows into the major super funds. There are only three funds with annual cash flows greater than $5 billion and fourteen with cash flows greater than $1 billion. After that, net cash flows across the remaining funds decline precipitously.

According to KPMG, the average net contribution across all funds in 2016 was 3.3%. Spaceship has raised over $100 million in member contributions in less than 12 months. That’s a net contribution equivalent to that of a $3 billion fund! And those members are young enough to keep contributing for decades.

A strong narrative makes compulsory super feel less compulsory

Let’s play a game of word association. Name something positive that comes to mind when you hear the word “compulsory”? Can you think of anything? I can’t. I can only think of negatives. Superannuation is compulsory. It should come as no surprise that most members aren’t engaged. Nobody enjoys being forced to do something.

Here’s where Spaceship is really clever. Linking super to a narrative – technology, the future, growth, etc. – creates the feeling that members are choosing to invest in a future that they believe in. Suddenly superannuation doesn’t feel compulsory anymore. Instead it’s something that you want to do because you believe in it. It’s even cool.

Show me an old-school super fund that’s been able to successfully market itself as cool? They’ve tried, sponsoring sports teams, advertising on the side of trams, TV commercials, celebrity endorsements, you name it. Still not cool.

Young people don’t care about insurance, advice, a call centre or any of the other stuff that adds cost to a super fund

Do you need insurance premiums eating into your super if you’re young and single? Probably not. Do you care about insurance if you don’t have a mortgage or dependents to maintain if something bad happens? Probably not.

Do you want investment advice? No because you don’t trust “experts”. You’d rather do some basic research on your smartphone and find something that’s right for you. Do you want to talk to someone if you have a question? No, you want to sort it out on an app at 9pm on Sunday evening.

In short, many of the value-added benefits that traditional super funds offer their members probably don’t matter that much to younger members.

The Bad

Cost

Customer acquisition

Marketing and an App don’t make a super fund

Cost

There’s not much to add except this: even if technology is the future, you’re unlikely to benefit much from investing in a fund such as Spaceship given its exorbitantly high fees.

Now I know that high fees are to some extent unavoidable for a start-up such as Spaceship. I get that. And I’m sure that they have every intention of lowering fees as they gain scale. I applaud that.

But the ethos of a tech start-ups is to improve the customer experience. And nothing kills the customer experience more powerfully than seeing your retirement savings being eroded by high fees.

There are several ways start-up funds to can their costs. It takes some investment know-how, but its possible (see below).

Customer acquisition

My guess is that is the biggest cost facing start-ups like Spaceship is customer acquisition. This is where the incumbents have the historical advantage. Industry funds benefit from the tailwind of default contributions courtesy of industrial agreements. Thanks to vertical integration, retail funds have historically been very profitable. Large profits have made it possible to spend heavily on marketing and, in times past, commissions to financial intermediaries offering their products.

I’m sure the folks at Spaceship know that achieving scale relatively quickly is important for several reasons:

Economies of scale – lower fees and charges create a better deal for members

The “flywheel effect” – lower costs mean the increase in profits can be split between the members (lower fees), improving its products and services and marketing; resulting in more members joining the fund

It provides proof that Spaceship is viable, making it easier and potentially cheaper for Spaceship to attract VC funding

It will help them to achieve a higher multiple sooner if they decide to sell the business

The big tests for Spaceship will be if it can:

Grow outside of its tech-loving hipster niche

Lower its costs fast enough

Marketing and an App don’t make a super fund

A football team may have a brand-new stadium, state-of-the-art training facilities and great support staff. But at the end of the day, it’s the team of players that take to the field each week that matters.

Yes, marketing and technology matter. Spaceship has clearly demonstrated that they are more effective at gaining new members than old school funds sponsoring football teams.

At the end of the day, the success of any super fund should rest on how well it helps its members to meet their retirement goals. There are three elements to meeting a retirement goal:

Saving while working

Investing

Spending during retirement

A super fund can only help with the investing part of the retirement equation. Sadly, I don’t see any of the new super funds doing enough on this front. They seem to be relying on a story and an app for customer acquisition and that’s it.

Now I don’t know why this is the case. Maybe they don’t think they need help. Or maybe they think the way established funds invest is too complicated (they are right!).

What they might not have thought of his how a smart investment strategy can:

Improve member retirement outcomes

Reduce costs

Allow for greater investment in product and marketing

Sound too good to be true? Here’s just one idea that might help.

Spaceship offers a single investment option. Here’s its strategic asset allocation as at 31/7/2017

The tech stocks consist mainly of US companies, along with a handful of Chinese tech companies, such as Tencent.

“The rest” consists mainly of Australian shares. A lot of ink has been spilled about why investing in Australian shares isn’t investing in the future. I’m not going to repeat those arguments here. What I am going to do is take a guess at why so much of what’s supposed to be a “tech” fund is invested in Australian shares. Here are some reasons:

Franking credits. Australian shares earn approximately 1.3% in additional return due to franking credits (tax paid at the corporate-level).

Foreign currency exposure. FX exposure helps to diversify a multi asset portfolio (as the AUD is positively correlated with equities). But after a certain point (15-25% exposure) FX exposure starts reducing return. The reason is that the AUD typically earns a positive carry due to interest rates usually being higher in Australia then the US.

Member liabilities are denominated in AUD and subject to AUD inflation.

As a fiduciary, the trustee administering the fund (which is not Spaceship) may be hesitant to invest any more of the fund in tech stocks.

The regulator might start asking questions if the tech allocation were any higher.

These are all important reasons. But they just don’t fit the “tech is sexy” narrative that Spaceship is going for. If it were me, I’d be transparent and explain why each of these reasons are important. and why they’ve resulted in the large allocation to Australian shares.

But I promised that I wasn’t going to debate whether or not this makes sense. What I am going to do is demonstrate how Spaceship could be paid, that’s right paid, to run a similar portfolio.

It involves using derivatives such as total return swaps to create a structured equity portfolio. Here’s how it works.

Spaceship invests its assets under management ($AuM) as follows:

90% in the Vanguard Australian Shares Index Fund ETF (VAS) at a fee of 0.14%

8% in the Vanguard Australian Fixed Interest Index ETF (VAF) at a fee of 0.20%

2% in cash

The physical assets are invested 100% in Australia. Spaceship now enters into a series of total return swaps to obtain the desired exposure to tech stocks (by swapping some of its exposure to Australian shares):

Short ASX 300, Long BBSW ± margin (value = approximately 35% of $AuM)

Short BBSW, long a basket of tech stocks ± margin (value = approximately 35% of $AuM)

An easier (and perhaps cheaper) way to do it would be to go long the NASDAQ 100 index. While not 100% tech stocks, there is significant overlap between Spaceships tech holdings (minus the Chinese stocks).

What does this achieve? For starters, the investment fees are 0.142% (assuming cash is held at zero fee).

The costs of the swap are embedded in the margin. Current pricing is for investors selling Australian equity exposure to receive a margin, while investors buying NASDAQ 100 equity exposure pay a margin. At the moment, the two margins roughly net out.

So why use a TRS? It would allow Spaceship to earn franking credits on 90% of the portfolio instead of only 55%. The additional franking credit (currently around 1.3%) would mean that the after-tax return would be around 0.40-0.50% higher per annum.

Spaceship could use the savings to lower costs to members, increase its advertising spend, invest in improvements to its product or a combination of all three. A higher return, better service and at a lower cost.

Of course, using swaps create other issues, such as:

Pricing depends on transaction size

Swap pricing is not static

Difficult to manage small inflows/outflows

Tax considerations such as the “30% Delta Rule”

Collateral management

ISDAs

Legal costs

Credit and counterparty risk exposures

All of which can be managed if you have the right people with the right skills and experience in investing.

The Hype

While investigating the Spaceship website, I found four marketing catch phrases:

Invest in the future

Invest your super in a diversified portfolio with technology at its core

Invest where the world is going not where it has been

Know exactly what you own

Here are some observations on each.

Invest in the Future

ALL investing happens in the future. Even an 80-year old that invests in a 3-year term deposit is making a bet on one or more risks (longevity, inflation, creditworthiness of the financial institution, etc) that will be affected by the future.

I’m guessing that in this context, the team at Spaceship are referring to the future of society, business, etc.It’s a great idea, except for one small wrinkle: the future is both uncertain and unknowable.

I agree that technology, the main focus of Spaceship, is highly likely to be at the centre of so much of what will happen in the future. But am I that sure that I’m willing to go all-in? Or would I be better off hedging my bets? And are there other opportunities that might also do well? Should I ignore them?

My career as an investor has taught me that the best way to deal with future is to bet on a range of outcomes not just a single outcome.

Of course, that doesn’t mean that we necessarily have to assign equal probability to every possible outcome. We can, and should, vary our estimates given what we know now and what we learn over time.

Invest your Super in a Diversified Portfolio with Technology at its Core

I have no doubt that technology will result in massive amounts of change. That’s why I’ve hedged my inability to write code by owning shares in several technology companies (I own 3 of the FAANGs, see if you can guess which). After all, if a robot’s going to take my job then I may as well own the robot!

But investing in technology is far from a sure thing. Here’s why:

There’s a big difference between picking a winner versus betting on mispriced odds

Can you predict the winners and losers in advance?

Technology wins but who benefits?

Will the successes of the winners outweigh the failures of the losers?

There’s a big difference between picking a winner versus betting on mispriced odds

An experienced punter will tell you that it’s hard to make money trying to pick winners. Think about it, if it’s obvious to you that a horse is an outright favourite, then it’s probably obvious to everyone else at the track. So, what happens to the odds if everyone bets on the favourite?

They collapse. The horse becomes an “unbackable favourite”. In other words, even if you’re right, the potential profit is so small it’s hardly worth taking the gamble.

In contrast, experienced punters look for mispriced odds. That is, the odds are more pessimistic than they should be. It doesn’t matter that the horse may not be a certain winner. What matters is that it has a chance and that this chance is more likely than the price suggests it should be.

What do you think is a better description of tech stocks: an unbackable favourite or mispriced odds?

Stop and think for a second. The fact that a start-up super fund is pitching itself as a “technology” fund suggests something about how the public view tech stocks.

Can you predict the winners and losers in advance?

This is always tough (the future is uncertain and unknowable) to do. Especially in an industry such as technology which is typified by short product cycles, and winner-take-all dynamics. This is the reason why a lot of hedge funds are active investors in technology companies. The wide dispersion between winners and losers provides the opportunity to benefit (loose) from successful (unsuccessful) stock-picking.

Does Spaceship make any attempt to pick stocks? I’m not sure as the Spaceship Product Disclosure Statement (PDS) is unclear on this.

It’s not always clear which link in the technological chain will benefit. For example, IBM developed the personal computer but they weren’t the ones that profited from it. None of the manufacturers of “IBM Compatible” PCs, HP, Compaq and Dell enjoyed long-term profitability either. The two companies that did benefit were Microsoft and Intel.

It’s also worth remembering that the “first mover” rarely wins. For every Excel, there’s a Lotus 123 (and a VisiCalc before that). For every Google, there’s a Yahoo!. And for every Facebook, there’s a Myspace.

Technology wins but who benefits?

Air travel was one of the greatest technological achievements of the 20th century. In less than 100 years, air travel went from the wood and fabric of Kitty Hawk, to the aluminium and carbon fibre of the modern airliner.

Who benefited from this? Manufacturers? No, most of them went bankrupt. The industry has consolidated over time into a handful of large-scale manufacturers (Boeing, Airbus, Embraer, etc.) Airlines? Similar story. A great number have either closed or merged. And many of those still operating today have experienced bankruptcy, often on several occasions.

The group that benefitted were the passengers or customers. Air travel went from being something that only the rich and famous could afford, to the equivalent of a long-distance bus fare.

What’s the point of this story? Technology will change the world, but that doesn’t guarantee that the developers of technology will be the ones that profit.

Will the successes of the winners outweigh the failures of the losers?

I don’t know, but that’s the bet that Spaceship’s members are taking. Whether or not this is the case depends largely on whether or not technology stocks are “mispriced odds” or “unbackable favourites”.

Invest where the World is Going not where it has Been

Great idea, so why limit the portfolio to just technology? Surely the future presents lots of other investment opportunities. Why restrict the definition of “technology” to information technology? Why not also invest in biotechnology or clean energy?

If we’re interested in “where the world is going” then what about emerging markets? Emerging markets now account for the majority of world GDP as this chart from The Economist shows:

They dominate trade, spending, production an investment.

And demographics suggest that these trends are likely to continue.

As the chart above shows, the world is literally going to emerging market countries. And yet, with the exception of a few Chinese technology stocks, Spaceship has no allocation to emerging market investments.

Not only does this make no sense from a “where the world is going” point of view, it also makes no sense from a diversification or a risk perspective. The US, where most technology companies are based, has a relatively expensive currency and high equity market valuations (especially in technology stocks). It also has high profit margins and high-levels of profitability. History suggests that both profit margins and profitability revert to the mean over time due to competitive forces.

In contrast, emerging markets countries have relatively inexpensive currencies. Market valuations are in-line with historical averages and a lot lower than they are in the US and other developed countries. Profitability and profit margins have stabilised after falling for several years and have now started to improve.

Investing in Emerging Markets looks like a no-brainer when its possible to:

Invest in countries experiencing the biggest population growth

At a relatively cheap price

At a time when corporate fundamentals are improving

And you can get good value for money on the currency conversion

Know Exactly what you Own

This is an essential part of doing business in the 21st century. There is simply no way for Spaceship, or any other super fund, to get around the negative feelings that come with “compulsion” unless they are completely transparent.

Conclusion

So there you have it, my totally unsolicited two cents worth on Spaceship and incumbent super funds. What’s the point of this exercise?

For Spaceship: Folks, I love the idea of what you’re trying to achieve but you’re not there yet. Perhaps you should consider enlisting the help of those with the skills and experience to take you to the next level?

For Old School Funds: You’ve been warned. Ignore what Spaceship has already achieved at your peril!